Surety Bonds versus Letters of Credit

Question
What are the differences between surety bonds and ILOCs (irrevocable letters of credit)? As an owner, does it matter if I call for a surety bond rather than an ILOC? Do I get “more” from a surety bond?

Answer
The following table summarizes some of the differences between ILOCs and surety bonds and why calling for surety bonds may be prudent and provide “more” protection for owners.

Surety Bonds

ILOCs

Prequalification of contractor

Sureties have an extensive process for prequalifying contractors and only issue bond(s) when they have the confidence that a contractor has the skills/talent, labour, equipment, cash and experience to be able to complete the work.

Banks issue ILOCs based their assessment of the contractor’s financial status. Banks do not assess a contractor’s past performance before issuing an ILOC.

Cash position

Sureties assess the working capital and cash flow of the contractor (principal). A surety bond does not negatively affect the ability of the contractor to access more bank credit.

An ILOC reduces a contractor’s line of credit which can cause cash flow issues during a project. The likelihood of default increase if the contractor does not have the cash flow and banking credit to pay the bills.

A contractor must have access to significant cash reserves and/or borrowing lines to secure an ILOC. This could lead to a reduction in the number of qualified contractors bidding which may increase the cost of the project.

Integrity of the security

Performance bonds and labour and material payment bonds cannot be cancelled. A standard CCDC Performance bond clearly states what constitutes completion of the work so there is no need for the obligee (owner) to ensure that the bond is still in force.

The onus is on the owner to ensure that the ILOC is still in force and has not been cancelled or expired.

On-going monitoring

Because sureties monitor a bonded contractor's entire work program on an on-going basis, they are often aware of problems that have the potential to negatively impact the bonded project. While these problems may have nothing to do with the bonded contract, sureties will use this information to work with the contractor to prevent performance problems on the bonded project.

Banks focus strictly on the contractor's ability to repay the outstanding amounts.

Trigger

Surety bonds are "on default" instruments. Therefore, the obligee (owner) must also honour its obligations and demonstrate that a default has occurred. The Canadian Construction Association and other industry groups recognize that surety bonds provide a fair balance between the rights and obligations of obligees (owners) and principals (contractors).

An ILOC may be demanded by the owner at any time for any reason providing little protection to the contractor to discuss issues at hand.

Performance Bond vs. ILOC

A performance bond guarantees that the obligee (owner) ends up with a completed project at the original contract price (plus approved change orders).

An ILOC does not provide a completed project. It only provides cash (usually 10% to 20% of the contract value). Surety industry claims experience indicates that average losses approach 40% of the contract value and there have even been cases when the loss exceeds 100% of the contract value. Therefore, it is likely the cash from an ILOC will not be sufficient to complete the project and the owner will greatly exceed its original budget.

Labour and Material Payment Bond vs. ILOC

A labour and material payment bond ensures payment to the defaulted principal’s (contractor’s) direct subcontractors and suppliers. Payment to these subcontractors and suppliers is handled by the surety, therefore no additional administrative burden falls to the obligee (owner).

The claims for non-payment and liens placed by subcontractors and suppliers can easily exceed the amount of the ILOC. The owner has to use its own resources to vacate the liens and secure clear title to the property.

Summary
Surety bonds represent the best means of providing full, non-intrusive protection against the perils of contractor default for the following reasons:

Prequalification
Surety bonds provide more than pure financial security and are issued only after an exhaustive evaluation and prequalification process. The process of evaluation and prequalification, which is at the heart of the surety product, provides owners (obligees) with the confidence that the contractor (principal) has sufficient management and business structures in place to assure success.

Cash Position
Surety bonds do not affect the contractor's (principal’s) cash and/or its banking facility. The contractor (principal) has full access to these resources which enables the company to expedite the completion of the bonded project.

Integrity of the Security
A surety bond is in force for the life of the contract and does not expire.

On-going Monitoring
Sureties monitor a bonded contractor's (principal’s) entire work program on an ongoing basis which often allows them to foresee potential problems and mitigate these issues before any impact has been realized on the bonded project.

Trigger
Surety bonds are "on default" instruments. They support the fairness of the underlying construction contract and require an owner (obligee) to honour its obligations and demonstrate that a default has occurred.

Completed Project
With a performance bond in place, when a default has been declared, the owner (obligee) will end up with a completed project at the amount it contracted.

Administrative Burden
A labour and material payment bond removes the administrative burden to the owner and ensures that subs and suppliers are paid in full. Any unpaid subs and/or suppliers with direct contracts on the project will not be required to lien a job. Once their bond claim has been validated they will be paid by the surety.

This information is intended to serve as a general guideline. Nothing contained herein should be construed as legal advice. Readers are cautioned to consult with legal counsel for such advice.

Glossary of Terms

Obligee
An individual or organization in whose favour an obligation is created and to whom a bond is given.

Principal
The individual or organization that bears the primary responsibility for fulfilling the obligation under the written contract referenced in the bond and that has the duty to perform for the Obligee’s benefit.

Surety
The party to a surety bond who answers to the Obligee for the Principal’s default or failure to perform as required by the underlying contract, permit or law.